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While the market is in awe of the recent surge in seemingly cheap liquidity, little if anything Contributing Rate Strategist
fundamental has changed to address the ongoing sovereign crisis, and absent any large-
scale policy response the Eurozone sovereign debt crisis will almost surely take a further Nick Firoozye
+44 (0) 20 7103 3611
turn for the worse. Given the ECB‟s reluctance or legal inability to monetize the debt, and nick.firoozye@nomura.com
the large wall of issuance coming (see Rates Flash – Quantifying the eurozone‟s 2012
financing requirements, 13 December 2011) taking place amidst the ongoing downgrades, Artis Frankovics
one of two alternatives is increasingly likely: Eurozone break-up (see Special Topic: +44 (0) 20 7103 7236
artis.frankovics@nomura.com
Currency risk in a Eurozone break-up – Legal Aspects, 18 November 2011) or large-scale
sovereign defaults. While our core view remains more hopeful, we take the opportunity to
look in detail at trading risky sovereigns (such as Italy), as credit. In particular, in this, the
first of a series of papers, we explain how credit traders would approach BTP spread trades, This report can be accessed
to gain on a restructuring, but as well gain on recovery. electronically via:
www.nomura.com/research or on
Bloomberg (NOMR)
Credit trading—always positioning for possible haircuts
While sovereign bonds such as BTPs, SPGBs, GGBs, etc, have largely been the domain of
so-called rates traders, as the sovereign debt crisis has unfolded, the investor base in
Europe has changed dramatically. In particular, as pension and insurance fund managers
have stepped out, distressed-debt, high-yield, and emerging markets traders have stepped
in. While traditional traders will admit that markets now trade like credit, little if any of the
methodology of credit has come across into rates.
Credit traders, typically having fewer instruments at their disposal, tend to use much more
coarse techniques in putting on trades than the traditionally complex rates trades. In general,
other than outright directional trades, cash credit investors will look to benefit from
positioning for or against a restructuring, doing so by trading the capital structure (e.g.,
senior vs sub or BOTs vs RepItaly vs BTPs which we leave to another note), rich/cheap to
recovery (e.g., CTZs vs BTPs vs BTPei‟s, again for another note), CDS basis trades, and
spread trades and purely directional trades.
Sovereign bonds themselves usually do not allow for most capital structure-style trades, with
rather limited notions of seniority and subordination, but they do offer a great diversity of
product types. Italy, for instance offers BOTs (bills), CTZs (discount notes), CCTs (floaters,
both Euribor and BOT-linked), BTPs (bonds), BTPei‟s (linkers), and Rep Italy international
bonds of many differing flavours, each class of which may have an entirely different
treatment in a restructuring. Furthermore, Italian bonds (BTPs and BTPei‟s) may be stripped
into constituent coupon and principal strips, where interest only (IO) coupons are entirely
fungible between the different issues and the principal only (PO) retains the reconstitution
1
option .
We will look to trade BTPs in this note, focusing in particular on spread trades, given that
purely directional trading tends to require greater conviction in both Italian finances and
market sentiment. Spread trades, by comparison we instead prefer to look at spread trades,
taking default into account, hedging it or having explicit views on the outcome of future
restructurings.
1
Although this reconstitution option will change from mid-2012 (see Italian Tesoro, Guidelines for Public Debt Management 2012), where all
new POs will be fully fungible with IOs of the same maturity, and old non-fungible strips can be exchanged with the Tesoro for new fungible
strips. This will bring Italian stripping practice in line with French and German. See the Tesoro website for more information on stripping.
Flatteners or forwards
Stressed credit curves typically flatten or invert and we have seen significant flattening of
SPGB and BTP curves during the heights of the crisis, with some modest recovery of late
(e.g., 5y-10y BTP at a recent high of 105bp, up from a low of -50bp last November), as seen
in Figure 1, while Irish, PGB and GGB curves remain largely flat or inverted as can be seen
in Figure 2. While there has been a recent easing of tensions, ongoing funding stresses and
sovereign downgrades are altogether likely to increase the flattening pressure.
50 -1000 10 200
8 150
0 -1500 6
100
SPGB 5/10 BTP 5/10
4
-50 -2000
2 50
PGB 5/10 (rhs) GGN 5/10 (rhs)
0 0
-100 -2500
Jan-09 Aug-09 Mar-10 Oct-10 May-11 Dec-11
2009 2014 2020 2025 2031
Rates traders position for stress via dv01 neutral flattening trades. While also doing dv01
neutral trades, it is common for credit traders to put on par-for-par or cash-for-cash (also
called proceeds-neutral) trades. Unlike the case of dv01-neutral flatteners, both of these
'flatteners' have positive duration, and are in some way akin to forwards - in particular the
par-for-par trade would be a forward bond trade save for any coupon mismatch before the
short maturity (what‟s a coupon spread between friends?). Rather than a pure forward, we
will show that they are more like a long straddle, benefitting both from recovery while
being neutral or positive to default.
In Figure 3, we see forward rates from a BTP spline curve, at various horizons for each of a
2yr, 5yr, 7yr and 10yr maturity. We note that the 2yr rate, 13yr forward peaks at 9.86%. This
corresponds to a 13yr-15yr slope trade, while the 5yr rate peaks between 11-12yrs at 9.72%,
corresponding to a 11yr-16yr slope trade. We note that forward rates are probably so high
% 2yr Yield
11 5yr Yield
7yr Yield
10
10yr Yield
9
3
0 5 10 15 20 25
Years forward
Source: Nomura
2
Nomura | European Rates Insights 23 January 2012
It would make perfect makes sense to put on a trade that would effectively make money as
long as 2yr yields are below 9.86% in 12yr time. Moreover, in the current environment, each
forward trade benefits from positive roll. If, on the other hand, yields are above this break-
even, it is unlikely that Italy will remain sustainable, and a restructuring would probably have
ensued. We explain in some detail the recovery values of these trades, where the investor
possibly benefits from or is indifferent to various haircuts.
Figure 4: BTP descriptive statistics (flattener/forward) Figure 5: Flattener/Forward trade descriptive statistics
DV01 Proceeds
Short Long Par for Par
Neutral Neutral
Maturity Aug-23 Nov-29 Weight (short leg) -1.20 -1.00 -0.95
Issued Feb-08 Nov-98 Cash-out 22.04 4.43 0.00
Coupon (%) 4.75 5.25 DV01 0.00 -1.51 -1.88
Price (clean, EUR) 86.16 82.79 VAR (EUR) -0.94 -0.75 -0.74
Price (dirty, EUR) 88.42 83.99 Curvature (EUR per bp2)* 0.39 0.54 0.58
Yield 6.47 6.95 Carry (1m, EUR) -0.03 0.04 0.06
Mod Duration 8.55 10.95 Roll (1m, EUR) 0.12 0.14 0.14
DV01 -7.56 -9.07 Carry & Roll (1m, EUR) 0.09 0.17 0.20
Convexity 88.27 157.23 Value (R - €90, t=0m) -17.93 0.00 4.51
Repo (1m, bp) 37.50 37.50 Value (R - €80, t=0m) -15.94 0.00 4.01
Carry (1m, bp) -0.04 -0.04 Value (R - €70, t=0m) -13.95 0.00 3.50
Carry (1m, EUR) 0.33 0.37 Value (R - €90, t=12m) -18.25 0.47 5.17
Roll (1m, bp) 0.01 0.03 Value (R - €80, t=12m) -16.25 0.47 4.67
Roll (1m, EUR) 0.10 0.24 Value (R - €70, t=12m) -14.26 0.47 4.17
nd
Source: Nomura, Reuters *2 derivative of price to interest rates. Source: Nomura
In an upward sloping yield curve the shorter maturity bond usually has a higher price and
lower duration than higher maturity bond. Consequently, for a fixed notional in the long bond,
the dv01-neutral trade will involve higher notional in short bonds (1.2x in Figure 5), the par-
for-par of course will be the same notional, and the proceeds-neutral will involve less
notional in the short bond (0.95x in Figure 5). Moreover, there is usually a positive cash-out
Figure 6: Price and Yields for the underlying BTPs Figure 7: 3m rolling volatility
Eur % Eur
115 9 0.70
95 5 0.40
90 4 0.30
85 3
0.20
Price (BTP 4.75 Aug-23)
80 2
Price (BTP 5.25 Nov-29)
Yield (BTP 4.75 Aug-23) 0.10
75 Yield (BTP 5.25 Nov-29) 1
70 0 0.00
Jan-09 Jun-09 Nov-09 Apr-10 Sep-10 Feb-11 Jul-11 Dec-11 Jan-09 Jun-09 Nov-09 Apr-10 Sep-10 Feb-11 Jul-11 Dec-11
3
Nomura | European Rates Insights 23 January 2012
for dv01-neutral and par-for-par trade, while cash-for-cash is flat (as showin in Figure 5 for
EUR 100mm in the long leg). The different notional weighting will also result in differing
sensitivities to parallel shifts; with the proceeds-neutral trade having the highest dv01,
followed by par-for-par, reflecting being long a 11yr forward 6yr bond.
The proceeds-neutral weighting can be seen in Figures 7, where we have the 3m realized
rolling volatility for each of the strategies with weights fixed as of Jan 2012 (i.e., current
weight used retroactively). We note that there are periods when our ranking of sensitivity
reverses and volatility of the dv01-neutral weighting becomes much higher than cash-for-
cash, as is the case since Dec-2011. This reversal is due to the fact that the steepening was
driven by much larger moves in the 12yr relative to 18yr. The volatility of the par-for-par is
2
similar to cash-for-cash due to the similarity of the weighting .
The different notional weighting also ensures that the 1m carry and roll is the highest for
proceeds-neutral trade followed by par-for-par and dv01 neutral flattener. Clearly, while all
would benefit from flattening and some form of restructuring, the proceeds-neutral trade,
with the largest carry has the longest staying power, while the dv01 neutral has a much
shorter fuse. The roll of course is less relevant recently.
Finally, we look to the trades in restructuring scenarios. In particular, we assume that both
short and long legs are restructured on the same terms, par for (very much reduced) par of
new longer maturity bonds (much as is case of the Greek PSI).Since par-for-par trade has
the same notional amount in both legs the value of the flattener in case of credit event will
be zero irrespective of the recovery value, and the investor can merely pocket the initial
premium (together with the carry from accumulated coupons and net financing). We see this
in Figure 5, where the trades are valued for 90%, 80% and 70% recovery values for
restructuring now and at 12 months in the future. In each trade, the net value (cash-out
together with subsequent valuation) is positive in a default event.
The value of the proceeds and dv01-neutral flatteners will depend on the recovery value,
with dv01-neutral benefitting from deeper haircuts (being net short-notional) and cash-for-
cash benefitting from more shallow haircuts. Irrespective, in the current environment, taking
Figure 8: Perturbing the DV01 neutral trade Figure 9: Perturbing the Par for Par weighted trade
2 2
R75 R75
5
Flattening Flattening
0
5
15
1.5 -1 1.5
0
10
-5
25
0
-5
R80 -2 R80 -1
0
10
1 5 1
-2
Yield change in short leg (pp)
0
5
-1
20
0.5 0.5
R85 R85
5
5
-1
0
0 Perturbations 0 Perturbations
15
R90 -2 0 R90 0 -1
-5 5 -3 -1
-2 2009 0
-0.5 -3 5 -0.5 2009 -2
0 2010 -4 0
10
2010
-1
2011 2011
-1 -1
R95 2012 R95 2012
5 Current Current
-1.5 -1 -1.5
5
0 0 5 5
-2 R1005 -3 5 -4 5 R100-5 -1 -2
-3 Steepening 0 0 Steepening
-3 0
-2 -4
0 -5 0 -2
0
-1
-2 -2
-2 -1.5 -1 -0.5 0 0.5 1 1.5 2 -2 -1.5 -1 -0.5 0 0.5 1 1.5 2
Yield change in long leg (pp) Yield change in long leg (pp)
2
We could construct a minimum-variance combination, by regressing 5yr bond and 10yr bond and b adjusting the dv01 weighting. This approach to an adjusts
for the common denominator in both bonds and is useful in situations when dv01-neutrality leads to too large a weighting on the short-end. This would lead to a
minimum variance portfolio where expected returns are formed from historic moves. We argue that it is more reasonable to consider explicit haircuts into our
expectations, and dv01-neutral and minimum variance trades will underperform in most credit events.
4
Nomura | European Rates Insights 23 January 2012
The discussion above can be summarized using contour plots (see Figures 8-10), which
indicate net trade values under different interest rate combinations with white-hot indicating
higher payoffs for each, and red-to-brown indicating higher losses). In the plots we perturb
both legs of the trade by up to 2pp on the either side, i.e. interest rate on the BTP 4.75%
Aug-23 (5.25% Nov-29) moves within the range of -2pp to +2pp from the current value of
2
R75
Flattening
20
1.5
30
5
0
-5
R80
15
1
Yield change in short leg (pp)
25
10
0.5
R85
0 Perturbations
20
0
5
-1 Haircut
Equal
0
R90 -5 5
-0.5 2009 -1
15
2010
-1 2011
R95 2012
10
Current
-1.5
R100 0 0
-1 5 -2 5
Steepening
-5 -1 -2
0
5
-2
-2 -1.5 -1 -0.5 0 0.5 1 1.5 2
Yield change in long leg (pp)
We have also superimposed historical yields for both securities from 2009 until 2012. These
clearly highlight the 2011 flattening, and recent recovery. We note BTP 4.75% Aug-23 /
5.25% Nov-29 slope of 53bp is significantly above the 2009-12 average of 38.6bp.
Irrespective, history has limited informational value except we note that potential downside
of the trade appears relatively limited.
While default is a possibility, the road to default is long and arduous and it is not unlikely that
yields will be much higher than spot prior to default. For the sake of comparison, we note
that the Greek yields are both much higher and inverted, with interpolated yields in 2023 at
29%, and in 2029 at 21.25%. This is true as well of PGB curves, with interpolated yields in
2023 at 14.2% and in 2029 at 10.5%. Similar moves would lead to positive P&L on all three
trades.
5
Nomura | European Rates Insights 23 January 2012
Alternatively we can consider selling high-coupon (high price) bonds for low-coupon bonds,
and in particular, we look to short BTP 9.00% Nob-2023 versus BTP 5.00% Mar-2025.
Unlike the previous curve trades, these have relatively high negative carry. But this negative
carry is more than compensated by large cash-out in case of the par-for-par trade at the
start of the trade or residual value for proceeds-neutral trade in case of a restructuring.
Figure 11: BTP descriptive statistics (high/low coupon) Figure 12: High/low coupon descriptive statistics
DV01 Proceeds
Short Long Par for Par
Neutral Neutral
Maturity Nov-23 Mar-25 Weight (short leg) -0.91 -1.00 -0.75
Issued Nov-93 Jul-09 Cash-out 18.85 28.86 0.00
Coupon (%) 9.00 5.00 DV01 0.00 0.76 -1.42
Price (clean, EUR) 113.93 85.15 VAR (EUR) -0.65 -0.79 -0.56
Price (dirty, EUR) 115.99 87.12 Curvature (EUR per bp2)* 0.12 0.04 0.25
Yield 7.22 6.72 Carry (1m, EUR) -0.23 -0.29 -0.13
Mod Duration 7.64 9.23 Roll (1m, EUR) 0.00 -0.01 0.02
DV01 -8.77 -8.01 Carry & Roll (1m, EUR) -0.23 -0.30 -0.11
Convexity 74.90 105.19 Value (R - €90, t=0m) 7.77 0.00 22.40
Repo (1m, bp) 37.50 37.50 Value (R - €80, t=0m) 6.91 0.00 19.91
Carry (1m, bp) -0.07 -0.04 Value (R - €70, t=0m) 6.04 0.00 17.42
Carry (1m, EUR) 0.63 0.35 Value (R - €90, t=12m) 4.97 -3.46 20.83
Roll (1m, bp) 0.01 0.01 Value (R - €80, t=12m) 4.10 -3.46 18.34
Roll (1m, EUR) 0.10 0.09 Value (R - €70, t=12m) 3.24 -3.46 15.85
nd
Source: Nomura, Reuters *2 price derivative to interest rates. Source: Nomura
Conclusion:
Given the significant staying power of the trade, we prefer the cash-for-cash BTP 4.75%
Aug-23 / 5.25% Nov-29 trade with positive carry for its positioning for a default with higher
recovery values, but equally poised for a lowering of Italian funding pressures due to its high
positive duration. We like this trade in particular because although Italy remains under
significant funding pressure, we believe that it is unlikely that a credit event should
materialize imminently.
While we believe any credit event in Italy will likely result in still high recoveries, it may be
seen as more prudent by some to remain recovery-neutral, and the par-for-par trade, with
modest negative carry, will be one of the easiest to justify for those who believe default is
more likely than not, but are unwilling to take a view on how Italy (and more importantly,
decision makers within the EU) will ultimately treat the private sector.
Trade recommendation
Sell EUR 95mm BTP 4.75% Aug-2023 versus buy EUR 100mm BTP 5.25% Nov-2029 as
proceeds-neutral flattener.
Sell EUR 100mm BTP 9.00% Nov-2023 versus buy EUR 100mm BTP 5.00% Mar-2025 as
par-for-par flattener
6
Nomura | European Rates Insights 23 January 2012
ISCLOSURE APPENDIX A1
ANALYST CERTIFICATIONS
We, Nick Firoozye and Artis Frankovics hereby certify (1) that the views expressed in this report accurately reflect our personal views about
any or all of the subject securities or issuers referred to in this report, (2) no part of our compensation was, is or will be directly or indirectly
related to the specific recommendations or views expressed in this report and (3) no part of our compensation is tied to any specific
investment banking transactions performed by Nomura Securities International, Inc., Nomura International plc or any other Nomura Group
company.
Mentioned companies
Issuer name Disclosures
BANK OF AMERICA CORP 123
BELGIUM GOVERNMENT BOND 11
CITIGROUP INC 16,17
FRANCE GOVERNMENT BOND OAT 11
GOVERNMENT OF PORTUGAL 11
Hellenic Republic 11
Kingdom of Belgium 8,11,48
Republic of Austria 8,11,48
Republic of Italy 11
Republic of Poland 8,48,49
SPAIN GOVERNMENT BOND 11
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Nomura | European Rates Insights 23 January 2012
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Nomura | European Rates Insights 23 January 2012
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